Commodity Prices Will Rise

There is not enough money being invested in energy to hold prices at current
levels. It costs a bundle to replace depleted sources of oil and gas. The
justification for increasing exploration budgets is hard to come by when countries
are (effectively) nationalizing companies' projects. There is also the problem
of actual production not meeting anticipated levels. And the matter - not,
by any means, confined to a single industry or country - of companies not
investing at all, terrorized as they are by our stark, raving, mad monetary
policy.

Andy Lees, proprietor of AML Macro Ltd.,
has warned the sky is falling for some time, to little avail. Two years ago,
in "How
to Look for a Job," I cited Andy's projection that the cost of energy
will increase from 5% of the world's GDP to 16% of its GDP. Since then, investment
has continued to flow into fun and finance, so both the jobs and financial
resources needed to replace energy, at least in equal measure to that consumed,
have probably expanded. (Fun and finance make a riveting partnership. From
the September 25, 2012, Financial Times: "Wall Street financial engineers
have devised... an index to add financial instruments that do not exist." This
is where the nation's investment is going.)

Replacing oil and gas deposits demands new capital investment. Exxon plans
to spend $37 billion on exploration during 2012. Exxon's oil and gas production
fell 5.5% in the first half of the year. Its earnings in the second quarter
of 2012 were less than one-half of those in the second quarter 2011. Some
of this was due to lower natural gas prices. Ergo, gas prices will rise.

Reuters reports Exxon's costs of exploration are soaring. The weighted price
of goods sold is falling. Exxon will cancel exploration. In fact, Exxon decided
to forego two of its six Polish shale-gas concessions on September 20, 2012.

This is not much in a $37 billion investment budget, but the burden of costs
goes on and on. Quoting myself from 2007: "Cambridge Energy Research Associates
(CERA) estimated the worldwide cost to produce oil and natural gas (labor
and equipment) had risen 53% since 2004. In some cases the rising costs have
led producers to scrap exploration. Exxon estimated the cost of building a
gas-to-liquids plant in Qatar at $3 billion in 2004. Current estimates having
risen to $18 billion. The joint project of Exxon and Qatar has been dropped." If
anyone has seen a recent CERA cost index, please pass it along.

Exxon, of course, is not the only frustrated driller. Quoting Andy Lees from
September 20, 2012: "Highlighting the difficulties of Arctic drilling, Royal
Dutch Shell announced that it has abandoned any hope of striking oil this
year after the ice moved in. Last week it was forced to unhook its drilling
vessel from anchors holding it to a drill site just one day after it started
drilling the first hole in the Chukchi seabed. Shell's activities in the Beaufort
Sea have been hit by similar issues which have also meant they have yet to
get a drill bit into the seabed. The remoteness, the extreme cold, the threat
from ice crushing equipment and the shortened season makes the economics shaky. "The
Arctic has a high cost of supply and it is going to take a high oil price
to keep it competitive until we can drive down the costs" according to ConocoPhilips.
Gazprom has also been reported to have shelved the development of the Shtokman
gas field in the Arctic because of surging costs. There were also reports
that natural gas bearing rock had been found off the Falkland Islands in the
South Atlantic raising the possibility of the most remote LNG plant in the
world being built if sufficient further gas reserves are found. Whether it
is depths, distances, temperatures or darkness, the environments we have to
work in are getting more and more extreme to maintain supplies."

There seems to be a consistent tendency for energy exploration projections
to come up short. In 2006, Canadian tar sands production was expected to rise
from one million barrels per day to 2.8 million bpd in 2012. Output has only
risen to 1.6 million bpd. Another example is the large Azeri-Chirag-Gunashil
oil field in Azerbaijan. After a new leg of investment was completed in 2008,
production was expected to reach 1 million barrels per day (bpd). It peaked
in 2010 at 823,000 bpd, averaged 684,000 bpd in the first half of 2012, and
is declining at a rate of 10% a year.

All the while, the world's economy is slowing down yet costs are rising. FedEx "an
economic bellwether as operator of the world's largest cargo airline, reduced
its profit outlook for the second time this year, citing a slower economy." (September
20, 2012) Fred Smith, chief executive officer of the company, said: "Exports
around the world have contracted and the policy choices in Europe, the
U.S. and China are having an effect on global trade." [Not a good one.
My italics. - FJS] Within a day, FedEx announced it is increasing shipping
rates an average of 5.9% on January 1, 2013.

The destructive central-banking distortions retard useful investment. This
is not an environment in which companies make long-term, capital-investment
commitments. Instead, the Federal Reserve has placed a bid under the asset-backed
securitization complex in its latest QEEEEEEE. The tapeworms did not need
encouragement. International Financing Review reported on September
15: "The US structured-credit market exploded with issuance in the past week,
as 24 transactions across ABS, RMBS, CMBS, and CLOs sent investors into a
feeding frenzy....Twelve ABS transactions, mostly auto-related (including
three sub-prime auto deals), were marketed to investors, with several achieving
impressive over-subscription levels and the tightest spreads in five years." On
September 7, 2012, Bloomberg posted a headline: "Goldman Sachs, Citigroup
Lead CMBS Sales in Most Deals Since '07." We need go no further.

The latest round of quantitative easing flows to Wall Street and feeds anxious
hopes of a housing recovery. That will not happen. Prices still have along
way to fall, although, in the meantime the perversions are straight out of
2007. From the September 19, 2012, Wall Street Journal: "HENDERSON,
Nev.-The latest sign that the housing market is bubbling to life: The artificial
waterfall at the entryway to Lake Las Vegas is again flowing. Few developments
were hit harder in the real estate crash than this mixed-use project in the
desert 20 miles southeast of Las Vegas. While overbuilding caused Las Vegas
to collapse during the housing crash, Lake Las Vegas was hit even harder.
At the height of the city's foreclosure crisis, one in every 45 homes received
a foreclosure filing, compared with one in every 13 in Lake Las Vegas. ....
Hedge-fund manager John Paulson's Real Estate Private Equity Group recently
snapped up 530 acres of developable land in Lake Las Vegas for $17 million
in cash from lenders.... During a visit earlier this summer, business was
brisk at a Ravella hotel bar which has Tuscan-inspired views of manicured
hedges surrounding a fire pit, with customers sipping martinis and noshing
on pappardelle with veal meatballs."

To quote the greatest perversion of 2007, celebrated former Federal Reserve
Chairman Alan Greenspan offered fin-de-siecle advice in May of that
year: "Enjoy it while it lasts."

Sheehan serves as an advisor to investment firms and endowments. He is the
former Director of Asset Allocation Services at John Hancock Financial Services
where he set investment policy and asset allocation for institutional pension
plans. For more than a decade, Sheehan wrote the monthly "Market Outlook" and
quarterly "Market Review" for John Hancock clients.

Sheehan earned an MBA from Columbia Business School and a BS from the U.S.
Naval Academy. He is a Chartered Financial Analyst.